Last week, both the US Federal Reserve Bank and the Bank of England made the decision not to raise interest rates.
It’s worth noting that in his press conference on Wednesday, Fed chair Jerome Powell used the words “careful” and “carefully” sixteen times, providing significant insight into how the central bank is determined to respond to data and proceed from here. Frankly, responding and acting “carefully” is exactly how all investors – our clients included – should behave in these times.
Indeed, when asked what might influence the Fed’s policy and the US economy in the near future, he listed five worrying factors: the UAW strike, a possible government shutdown, the resumption of student loan payments, higher-for-longer interest rates and the recent spike up in oil prices. The words “uncertain” and “uncertainty” also figured prominently in his brief – an indication of the unstable world we live in.
Most commentators would agree that adopting a cautious approach to investing would be wise, given the sheer number of unknowns on the horizon. Although the bull market that got underway in October 2022 has been fairly resilient thus far, the S&P 500 Index does seem to have stalled in recent weeks. It has even drifted back just shy of 6% since the end of July 2023. It is just possible that it could retreat even further, testing its 200-day moving average of around 4200. This would constitute an 8.5% pullback since its recent high on 31 July this year.
The recent weakness in the index can be linked to credit rating agency Fitch's decision to downgrade the US Long-Term Foreign Currency Issuer Default Rating from AAA to AA+ on 1 August. Both the bond and equity markets have suffered in the ensuing couple of months. Nevertheless, we still expect the index to rally back up to around 4600 by the end of the year, and then 5400 by the end of 202
He also played down any possibility of interest rates falling any time soon. Inflation may be retreating for now, but the recent jump in energy prices could trigger a second wave as we enter the winter months.
In the UK, there was some surprise over the Bank of England's decision not to raise interest rates, after 14 consecutive hikes. Needless to say, it brought relief to homeowners with mortgages and people with consumer loans. However, Andrew Bailey warned against “complacency” and any premature celebrations in the battle to tame inflation: there is still a long way to go before we reach the 2% target rate.
Indeed, the International Monetary Fund was quick to point out how unstable energy prices had been since the start of the Russia-Ukraine war in February 2022, and how similar events in the 1970s had led to a period of inflation that proved hard to bring under control.
Central bankers are engaged in a delicate balancing act – trying to tame inflation on the one hand, while safeguarding or improving economic growth on the other. Yes, raising interest rates does dampen down inflation – people lose their appetite for borrowing money and they curb their household spending. But if monetary tightening is too aggressive, it can cause a different set of problems. Hitting households for a long period of time results in a fall in living standards. Ultimately, people's physical and mental health are impacted…
If, on the other hand, people have more disposable income, their spending increases, helping businesses to expand. Unemployment falls and the economy improves. Tougher business conditions – like those recently seen in the UK – have pushed the Purchasing Managers’ Index into contraction territory – its lowest score since the lockdowns of the pandemic.
This recent PMI reading has led to sterling dipping against both the US dollar and the euro – a sign that the last few interest rate hikes are starting to feed through into the economy, affecting how FX traders view the pound.
Meanwhile, the FTSE 100 Index has risen by just over 3% since the beginning of September – aided by the rise in oil prices and its exposure to the energy sector more widely. Also, the dip in sterling acts as a tailwind for corporate profitability for UK multinational exporting businesses.
Conversely, however, it acts as a drag on UK small and mid-cap companies: it adds further costing pressures to their margins… pressures which larger businesses are better able to absorb.
Both inflation and interest rates now look as though they are going to remain higher for longer. Higher rates can put pressure on some segments of the stock and bond markets, while creating opportunities for other segments.
As far as equities are concerned, we would expect a broadening out of leadership to emerge as rates remain elevated. Quality growth and the technology sector should continue to deliver favourable returns. But we should also see cyclical sectors – industrials, materials, small-caps and other international stocks outside the US – catching up.
In bonds, we currently like short-duration cash-like instruments that offer 5% plus yields. But as long-term investors who expect the central banks to pivot lower with their monetary policies at some point, there will be more attractive opportunities forming in longer-duration investment grade bonds. For now, however, patience is a virtue.
September is supposedly the worst month of the year for investment returns, and there are now just a few trading days of it left. Attention is now shifting to the final quarter of the year – what many regard as the best in terms of returns. The bull market may have sustained something of a minor bruising in the final weeks of the summer, but it remains intact: the MSCI World Index is up just under 4% if you exclude the US. However, this figure rises to 8.5% for the calendar year if you include Wall Street.
